The Insanity of the Cyprus Crisis

Cyprus did not manufacture its banking crisis. The European Central Bank and European Union bear that responsibility, yet Cypriots will pay the price for their dysfunctions.

Until recently, Cyprus was a prosperous island economy with robust tourism, shipping and a significant international banking sector. Its big banks, like others in Europe, attracted large overseas deposits and invested heavily in sovereign debt. In Cyprus, much of the money came from Russia and was invested in Greek bonds.

Like the United States, the large banks are subject to stress tests but with an important distinction. The Federal Reserve is responsible both for undertaking those tests and sustaining the operation and protecting depositors of large money center banks in a crisis. During the recent financial meltdown, the Federal Reserve printed billions of dollars to purchase souring bonds and the U.S. Treasury borrowed to inject new capital into large banks when their mortgage backed securities failed.

In the Eurozone, the European Banking Authority undertakes those stress tests, and in 2010 and 2011, well aware of their considerable holdings in Greek bonds, determined Cypriot banks had plenty of capital to withstand a financial crisis.

Meanwhile, Greece was in the throws of a financial crisis, and in February 2012, European Central Bank and European Union, along with the International Monetary Fund, imposed a 53.5 percent haircut on private bondholders—for all practical purposes, that sunk the large Cypriot banks and manufactured their crisis.

Unlike the Federal Reserve, the European Central Bank lacks the authority to print money to rescue failing banks. European Banking Authority is an arm of the European Union, which lacks the borrowing authority of the U.S. Treasury and the taxing capacity to back up bonds. Hence neither the ECB nor EU is in a position to bail out the Cypriot banks without substantial contributions and consent from the largest and healthiest European economy, Germany. (Related: Cyprus Should Leave the Euro)

Germany might be willing to extend ECB the authority to print money and the EU to borrow and tax to save banks in Frankfurt but not in Cyprus or just about anyplace outside Germany. Domestic politics prevent its government from borrowing and taxing to bail out other troubled European banks and governments without extracting a high price from private actors. In Greece, those were private bondholders—which included banks spread throughout Europe but most heavily those in Cyprus.

Simply, Cypriot banks hardly have enough capital to cover their losses on Greek sovereign debt, and their economy is too small to afford the Cypriot government the borrowing and taxing capacity to rescue them.

In exchange for €10 billion in aid, the ECB and EU are demanding that Cypriot banks be downsized—banking in Cyprus can be no larger than the average for the entire European Union. Moreover, under Eurozone rules, championed by Germany, austerity—cuts in government spending and strict limits on deficits—will be required.

In Cyprus, the loss of international banking will impose double digit unemployment—perhaps as high as 20 percent—because this small island economy cannot devalue its currency to attract new investment, as Iceland did after its crisis. Most laid off workers, whose native tongue is generally Greek, have few employment options elsewhere in Europe.

Thanks to a crisis manufactured by the European Central Bank and European Union, with the help of the International Monetary Fund, Cyprus will join Spain, Portugal and Greece in a permanent recession. (Related: European Default Has to Happen)

Spain suffered a similar banking crisis premised on foreign money inflows and real estate loans and similar problems engineering a recovery. And the contrast between Spain and Cyprus, who are locked into the euro, and Iceland, which has its own currency and recovered, plainly illustrates the euro does not make sense for these economies.

Germany's prescription for all these economies is austerity. Observing failed experiences with those policies across the Mediterranean recalls the definition of insanity—doing the same thing over and over again but expecting a different result.

The bailout terms and prescriptions for restructuring imposed on Cyprus are nothing short of insane, and the only sane course would be for Cyprus and the other Club Med States to negotiate an orderly withdrawal from the euro.

-- Peter Morici is an economist and professor at the Smith School of Business,, University of Maryland, and widely published columnist.